Don't let it get away!

I've been covering the solar sector for the Fool for several years now. How many solar stocks have I invested in since that time? Exactly zero.

I've touched upon several reasons for avoiding the space, but I've never collected them all in one place. I actually have more than I can fit in this one article, but I'll try to hit on three of the most persistent, big-picture concerns I have.

Cash me up, Scotty!When Yingli Green Energy (NYSE: YGE) came public amid a surge of solar IPOs in mid-2007, I was put off by the fact that the company was reporting positive earnings while consuming lots of cash (hence the share offering). There were actually two concerns entwined in that first skeptical take. The first was a "quality of earnings" matter. The second had to do with the ongoing dependence on external financing.

I returned to this two-fold problem a year later, in a pair of extremelyunpopular articles. Given the weak cash flow numbers being reported by shops like LDK Solar (NYSE: LDK) , I was worried about these firms' fundraising needs. I urged investors to "think about what would happen if the capital markets closed up shop for a while." I was naturally accused of being a "short seller trying very hard to create chaos and panic for self-serving interest." At least I got credit for being a hard worker!

The good news on the cash flow front is that working capital requirements have eased considerably since 2007. With polysilicon now in abundance, once-restrictive supplier prepayments have fallen by the wayside. That's huge for firms like Yingli, which increased prepayments by $200 million in 2007. In 2008, the firm's net cash provided by operations swung from deeply negative to a positive $140.4 million.

We won't have the full picture on 2009 for another month or two, as most Chinese players have yet to file annual reports. If First Solar (Nasdaq: FSLR) and Trina Solar (NYSE: TSL) are at all representative, though, the quality of earnings in this sector has improved a great deal.

Scotty? You there, buddy?With a less constrained supply chain, I'm feeling better about solar wafer/cell/module manufacturers' ability to generate cash flow. Does that allay my concerns about reliance on external financing? Not really.

Look at Trina Solar. The company just filed its annual report, showing cash flow in line with net income. In the section on liquidity, the company noted that it expected its cash, bank borrowings, and anticipated cash flow to meet its cash needs, including capital expenditures, for the next year.

Of course, Trina immediately contradicted that statement by announcing a follow-on equity offering of 7.9 million American depositary shares -- more than it issued in connection with its IPO! What a joke.

Trina is running circles around many of its global rivals, and isn't particularly hard up for cash. If Trina needs to keep tapping the capital markets, I expect its peers to do the same. That can get tough -- and highly dilutive to existing shareholders -- when sentiment sours.

Competition's great -- unless you're one of the competitorsWhile photovoltaic modules come in a few flavors, solar PV is a highly commoditized industry. In such a business, the low-cost producer wins. Every player is incentivized to slash costs, which conforms to the societal goal of making solar cheaper and more competitive with other forms of energy. This race to drive down the cost of solar has been, and will continue to be, relentless.

I've always doubted my ability to predict the eventual winners of this drag-out fight among the incumbents. While I saw encouraging signs during the sector's darkest hours, I didn't foresee Trina pulling ahead of the pack as strongly as it did. Think about how much the solar market, or the world economy, has changed in the past three years. Who will be on top three years from now? I have no idea.

As if the competitive rivalry among incumbents weren't intense enough, there's also the very credible threat of new entrants. Again, given the potential size of the solar market, this sector is going to keep attracting new firms like moths to a flame. I've written regularly about the solar ambitions of firms like Siemens (NYSE: SI) , IBM (NYSE: IBM) , and BYD. There are countless others out there, from small startups with revolutionary ideas to large conglomerates with vast resources. Most likely, the latter will swallow up the former, and then take the product to market. That's exactly what's happened with General Electric (NYSE: GE) . Having upped its stake in thin-film shop PrimeStar back in 2008, GE says it's working around the clock to deliver a breakthrough product to market.

If you've studied the work of Clayton Christensen, you know how disruptive innovation can turn an industry on its head. GE may not be the one to usher in such a change -- it may only achieve an incremental improvement over First Solar's panels -- but the risk is out there, and I can't quantify the potential impact. Even short of introducing disruptive solar technologies, new entrants will certainly have the effect of driving down industry profit margins.

Not the last wordSo there are my top three reasons not to invest in solar stocks: dependence on external financing, intense competition among incumbents, and the threat of new entrants. If you've come to different conclusions on these issues, please share your thoughts in the comments section. We all benefit from a diversity of viewpoints.

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First Solar, Nano Solar, and Applied Materials all claim they will reach the goal of less than $1/W manufacturing cost in 2010. Does anyone have a good guess of how that translates to installed customer costs for say 1 MW sized systems, including electronics to tie into the grid? At $2/W and 2500 sunny hours per year in a good location, we have an implied revenue of 20 cents per year @ 8 cents per KWH....which seems to yield a 10 year payback. This assumes no maintenance cost or value to the real estate occupied and no outside subsidies. These out of the air assumptions make it seem to me that PV is not yet competitive economically with windmills or gas fire plants but are not terribly far away if the learning curve on costs continue over the next few years. Any informed comments?

Generally speaking, I almost never actively try to avoid an entire sector, unless there is some reason to believe the entire sector will cease to exist (say and investment in horse drawn carriages at the turn of the 20th century). I do not believe that to be the case with solar, and in fact, you seem to imply the market will continue to grow at a rapid pace. With that in mind, the goal then becomes to find the best opportunity in the sector. A superior operator selling at a reasonable value. First Solar is my favorite at the moment. Strong earnings growth and free cash flow, a history of beating estimates, a superior operator and innovator, and at the moment, the low cost provider of solar power.

So, my question is, do you really mean to say you would avoid the entire sector, or are there just a lot of companies in the sector you don't like? The latter I can agree with, This article has not convinced of the former.

I work in the energy business, and the number one reason not to invest is that solar energy is not an economically viable source of electricity. The price to generate one KWH of electricity from solar is much greater than the cost of generation electricity from other renewables such as wind, hydro or biomasss. Also, the huge increase in the domestic supply of natural gas will serve to put further downward pressure on electric prices, making it almost impossible for solar to compete on price. Governments are going to stop subsidizing solar, realizing there are much cheaper ways to produce clean electricity. Solar, at best, will be relegated to a very small niche supplier of electricity.

The biggest reason not to buy solar is the articles written by Motley Fool and the Street. TSL revenue growth was over 40 percent and it's profit margin was 32%. It also predicted large revenue growth for the rest of the year. The relentless bad news articles make these stocks go down. Don't Buy!

Another great reason! I said I had more than could fit in one article, but mentioned this fact in my CAPS blog.

bigpeach,

I have avoided the sector since 2007, as I mentioned. I haven't sworn a blooad oath, though. Some of these stocks I would not own at any price, but there are several that I would consider, if they got cheap enough to compensate for the huge risks I perceive. A "stealth" play on solar through a company with other cash cow product lines could be another avenue I wouldn't rule out.